Carried Interest

Limited partners (the investors) put up nearly all the capital but want the people running the fund to care deeply about returns, not just about collecting fees. Carried interest solves this: by giving the GP a fat slice (typically 20%) of the profits, the GP only gets truly rich if the LPs do well. A $1bn fund that returns 2.0x generates $1bn of profit, of which carry alone is ~$200m — dwarfing the management-fee income. This is why partners at megafunds make most of their money from carry, and why junior bankers gunning for PE are really chasing a future carry check, not a salary.

Carry is paid out through the fund's distribution waterfall, in strict order: (1) return of capital — LPs get back 100% of contributed capital; (2) preferred return — LPs receive their hurdle (commonly 8% IRR); (3) GP catch-up — the GP takes 80-100% of profits until it has caught up to its 20% share of total profits above the return of capital; (4) carry split — remaining profits split 80/20 (LP/GP). So carry is the GP's 20% slice in steps 3 and 4. Funds run this either as a whole-fund (European) waterfall — carry only after the entire fund's capital is returned — or a deal-by-deal (American) waterfall, where carry can be taken per profitable deal earlier.

Carried interest is treated as a capital gain, not as ordinary income, because legally it is a share of the partnership's investment profits rather than a fee for services. That means GPs historically paid the long-term capital gains rate (~20%) instead of the top ordinary income rate (~37%). The 2017 Tax Cuts and Jobs Act added a 3-year holding-period requirement for long-term treatment. Critics call this the "carried interest loophole" because it lets fund managers pay a lower rate on what looks like compensation. In interviews you don't need the tax law cold, but knowing carry is taxed as capital gains signals real understanding.

Carry is free upside — the GP risks no capital to earn it. Separate from carry, GPs also make a GP commitment (typically 1-5% of fund size) of their own money into the fund, so they have skin in the game on the downside too. Don't confuse the two: carry is the performance share of LP profits; the GP commit is the GP's own invested capital that earns returns like any LP. Clawback provisions can also force the GP to return excess carry if later losses mean it was overpaid early in a deal-by-deal structure.